The performance of the U.S. economy over the past
year has been quite favorable. Real GDP growth picked
up to more than three percent over the four quarters of
1996, as the economy progressed through its sixth year
of expansion. Employers added more than two-and-a-half
million workers to their payrolls in 1996, and the
unemployment rate fell further. Nominal wages and
salaries have increased faster than prices, meaning
workers have gained ground in real terms, reflecting
the benefits of rising productivity. Outside the food
and energy sectors, increases in consumer prices
actually have continued to edge lower, with core CPI
inflation only 2-1/2 percent over the past twelve
months.

Low inflation last year was both a symptom and a
cause of the good economy. It was symptomatic of the
balance and solidity of the expansion and the evident
absence of major strains on resources. At the same
time, continued low levels of inflation and inflation
expectations have been a key support for healthy
economic performance. They have helped to create a
financial and economic environment conducive to strong
capital spending and longer-range planning generally,
and so to sustained economic expansion. Consequently,
the Federal Open Market Committee (FOMC) believes it is
crucial to keep inflation contained in the near term
and ultimately to move toward price stability.

Looking ahead, the members of the FOMC expect
inflation to remain low and the economy to grow
appreciably further. However, as I shall be
discussing, the unusually good inflation performance of
recent years seems to owe in large part to some
temporary factors, of uncertain longevity. Thus, the
FOMC continues to see the distribution of inflation
risks skewed to the upside and must remain especially
alert to the possible emergence of imbalances in
financial and product markets that ultimately could
endanger the maintenance of the low-inflation
environment. Sustainable economic expansion for 1997
and beyond depends on it.

For some, the benign inflation outcome of 1996
might be considered surprising, as resource utilization
rates--particularly of labor--were in the neighborhood
of those that historically have been associated with
building inflation pressures. To be sure, an
acceleration in nominal labor compensation, especially
its wage component, became evident over the past year.
But the rate of pay increase still was markedly less
than historical relationships with labor market
conditions would have predicted. Atypical restraint on
compensation increases has been evident for a few years
now and appears to be mainly the consequence of greater
worker insecurity. In 1991, at the bottom of the
recession, a survey of workers at large firms by
International Survey Research Corporation indicated
that 25 percent feared being laid off. In 1996,
despite the sharply lower unemployment rate and the
tighter labor market, the same survey organization
found that 46 percent were fearful of a job layoff.

The reluctance of workers to leave their jobs to
seek other employment as the labor market tightened has
provided further evidence of such concern, as has the
tendency toward longer labor union contracts. For many
decades, contracts rarely exceeded three years. Today,
one can point to five- and six-year contracts--contracts that are commonly characterized by an
emphasis on job security and that involve only modest
wage increases. The low level of work stoppages of
recent years also attests to concern about job
security.

Thus, the willingness of workers in recent years
to trade off smaller increases in wages for greater job
security seems to be reasonably well documented. The
unanswered question is why this insecurity persisted
even as the labor market, by all objective measures,
tightened considerably. One possibility may lie in the
rapid evolution of technologies in use in the work
place. Technological change almost surely has been an
important impetus behind corporate restructuring and
downsizing. Also, it contributes to the concern of
workers that their job skills may become inadequate.
No longer can one expect to obtain all of one's
lifetime job skills with a high-school or college
diploma. Indeed, continuing education is perceived to
be increasingly necessary to retain a job. The more
pressing need to update job skills is doubtless also a
factor in the marked expansion of on-
the-job training programs, especially in technical
areas, in many of the nation's corporations.

Certainly, other factors have contributed to the
softness in compensation growth in the past few years.
The sharp deceleration in health care costs, of course,
is cited frequently. Another is the heightened
pressure on firms and their workers in industries that
compete internationally. Domestic deregulation has had
similar effects on the intensity of competitive forces
in some industries. In any event, although I do not
doubt that all these factors are relevant, I would be
surprised if they were nearly as important as job
insecurity.

If heightened job insecurity is the most
significant explanation of the break with the past in
recent years, then it is important to recognize that,
as I indicated in last February's Humphrey-Hawkins
testimony, suppressed wage cost growth as a consequence
of job insecurity can be carried only so far. At some
point, the tradeoff of subdued wage growth for job
security has to come to an end. In other words, the
relatively modest wage gains we have experienced are a
temporary rather than a lasting phenomenon because
there is a limit to the value of additional job
security people are willing to acquire in exchange for
lesser increases in living standards. Even if real
wages were to remain permanently on a lower upward
track than otherwise as a result of the greater sense
of insecurity, the rate of change of wages would revert
at some point to a normal relationship with inflation.
The unknown is when this transition period will end.

Indeed, some recent evidence suggests that the
labor markets bear especially careful watching for
signs that the return to more normal patterns may be in
process. The Bureau of Labor Statistics reports that
people were somewhat more willing to quit their jobs to
seek other employment in January than previously. The
possibility that this reflects greater confidence by
workers accords with a recent further rise in the
percent of households responding to a Conference Board
survey who perceive that job availability is plentiful.
Of course, the job market has continued to be quite
good recently; employment in January registered robust
growth and initial claims for unemployment insurance
have been at a relatively low level of late. Wages
rose faster in 1996 than in 1995 by most measures,
perhaps also raising questions about whether the
transitional period of unusually slow wage gains may be
drawing to a close.

To be sure, the pickup in wage gains has not shown
through to underlying price inflation. Increases in
the core CPI, as well as in several broader measures of
prices, have stayed subdued or even edged off further
in recent months. As best we can judge, faster
productivity growth last year meant that rising
compensation gains did not cause labor costs per unit
of output to increase any more rapidly. Non-labor
costs, which are roughly a quarter of total
consolidated costs of the nonfinancial corporate
sector, were little changed in 1996.

Owing in part to this subdued behavior of unit
costs, profits and rates of return on capital have
risen to high levels. As a consequence, businesses
believe that, were they to raise prices to boost
profits further, competitors with already ample profit
margins would not follow suit; instead, they would use
the occasion to capture a greater market share. This
interplay is doubtless a significant factor in the
evident loss of pricing power in American business.

Intensifying global competition also may be
further restraining domestic firms' ability to hike
prices as well as wages. Clearly, the appreciation of
the dollar on balance over the past eighteen months or
so, together with low inflation in many of our trading
partners, has resulted in a marked decline in non-oil
import prices that has helped to damp domestic
inflation pressures. Yet it is important to emphasize
that these influences, too, would be holding down
inflation only temporarily; they represent a transition
to a lower price level than would otherwise prevail,
not to a permanently lower rate of inflation.

Against the background of all these considerations,
the FOMC has recognized the need to
remain vigilant for signs of potentially inflationary
imbalances that might, if not corrected promptly,
undermine our economic expansion. The FOMC in fact has
signaled a state of heightened alert for possible
policy tightening since last July in its policy
directives. But, we have also taken care not to act
prematurely. The FOMC refrained from changing policy
last summer, despite expectations of a near-term policy
firming by many financial market participants. In
light of the developments I've just discussed affecting
wages and prices, we thought inflation might well
remain damped, and in any case was unlikely to pick up
very rapidly, in part because the economic expansion
appeared likely to slow to a more sustainable pace. In
the event, inflation has remained quiescent since then.

Given the lags with which monetary policy affects
the economy, however, we cannot rule out a situation in
which a preemptive policy tightening may become
appropriate before any sign of actual higher inflation
becomes evident. If the FOMC were to implement such an
action, it would be judging that the risks to the
economic expansion of waiting longer had increased
unduly and had begun to outweigh the advantages of
waiting for uncertainties to be reduced by the
accumulation of more information about economic trends.
Indeed, the hallmark of a successful policy to foster
sustainable economic growth is that inflation does not
rise. I find it ironic that our actions in 1994-95
were criticized by some because inflation did not turn
upward. That outcome, of course, was the intent of the
tightening, and I am satisfied that our actions then
were both necessary and effective, and helped to foster
the continued economic expansion.

To be sure, 1997 is not 1994. The real federal
funds rate today is significantly higher than it was
three years ago. Then we had just completed an
extended period of monetary ease which addressed the
credit stringencies of the early 1990s, and with the
abatement of the credit crunch, the low real funds rate
of early 1994 was clearly incompatible with containing
inflation and sustaining growth going forward. In
February 1997, in contrast, our concern is a matter of
relative risks rather than of expected outcomes. The
real funds rate, judging by core inflation, is only
slightly below its early 1995 peak for this cycle and
might be at a level that will promote continued non-
inflationary growth, especially considering the recent
rise in the exchange value of the dollar. Nonetheless,
we cannot be sure. And the risks of being wrong are
clearly tilted to the upside.

I wish it were possible to lay out in advance
exactly what conditions have to prevail to portend a
buildup of inflation pressures or inflationary
psychology. However, the circumstances that have been
associated with increasing inflation in the past have
not followed a single pattern. The processes have
differed from cycle to cycle, and what may have been a
useful leading indicator in one instance has given off
misleading signals in another.

I have already discussed the key role of labor
market developments in restraining inflation in the
current cycle and our careful monitoring of signs that
the transition phase of trading off lower real wages
for greater job security might be coming to a close.
As always, with resource utilization rates high, we
would need to watch closely a situation in which demand
was clearly unsustainable because it was producing
escalating pressures on resources, which could
destabilize the economy. And we would need to be
watchful that the progress we have made in keeping
inflation expectations damped was not eroding. In
general, though, our analysis will need to encompass
all potentially relevant information, from financial
markets as well as the economy, especially when some
signals, like those in the labor market, have not been
following their established patterns.

The ongoing economic expansion to date has
reinforced our conviction about the importance of low
inflation--and the public's confidence in continued low
inflation. The economic expansion almost surely would
not have lasted nearly so long had monetary policy
supported an unsustainable acceleration of spending
that induced a buildup of inflationary imbalances. The
Federal Reserve must not acquiesce in an upcreep in
inflation, for acceding to higher inflation would
countenance an insidious weakening of our chances for
sustaining long-run economic growth. Inflation
interferes with the efficient allocation of resources
by confusing price signals, undercutting a focus on the
longer run, and distorting incentives.

This year overall inflation is anticipated to stay
restrained. The central tendency of the forecasts made
by the Board members and Reserve Bank presidents has
the increase in the total CPI slipping back into a
range of 2-3/4 to 3 percent over the four quarters of
the year. This slight falloff from last year's pace is
expected to owe in part to a slower rise in food prices
as some of last year's supply limitations ease. More
importantly, world oil supplies are projected by most
analysts to increase relative to world oil demand, and
futures markets project a further decline in prices, at
least in the near term. The recent and prospective
declines in crude oil prices not only should affect
retail gasoline and home heating oil prices but also
should relieve inflation pressures through lower prices
for other petroleum products, which are imbedded in the
economy's underlying cost structure. Nonetheless, the
trend in inflation rates in the core CPI and in broader
price measures may be somewhat less favorable than in
recent years. A continued tight labor market, whose
influence on costs would be augmented by the scheduled
increase in the minimum wage later in the year and
perhaps by higher growth of benefits now that
considerable health-care savings already have been
realized, could put upward pressure on core inflation.
Moreover, the effects of the sharp rise in the dollar
over the last eighteen months in pushing down import
prices are likely to ebb over coming quarters.

The unemployment rate, according to Board members
and Bank presidents, should stay around 5-1/4 to 5-1/2
percent through the fourth quarter, consistent with
their projections of measured real GDP growth of 2 to
2-1/4 percent over the four quarters of the year. Such
a growth rate would represent some downshifting in
output expansion from that of last year. The projected
moderation of growth likely would reflect several
influences: (1) declines in real federal government
purchases should be exerting a modest degree of
restraint on overall demand; (2) the lagged effects of
the increase in the exchange value of the dollar in
recent months likely will damp U.S. net exports
somewhat this year; and (3) residential construction is
unlikely to repeat the gains of 1996. On the other
hand, we do not see evidence of widespread imbalances
either in business inventories or in stocks of
equipment and consumer durables that would lead to a
substantial cutback in spending. And financial
conditions overall remain supportive; real interest
rates are not high by historical standards and credit
is readily available from intermediaries and in the
market.

The usual uncertainties in the overall outlook are
especially focused on the behavior of consumers.
Consumption should rise roughly in line with the
projected moderate expansion of disposable income, but
both upside and downside risks are present. According
to various surveys, sentiment is decidedly upbeat.
Consumers have enjoyed healthy gains in their real
incomes along with the extraordinary stock-market
driven rise in their financial wealth over the last
couple of years. Indeed, econometric models suggest
that the more than $4 trillion rise in equity values
since late 1994 should have had a larger positive
influence on consumer spending than seems to have
actually occurred.

It is possible, however, that households have been
reluctant to spend much of their added wealth because
they see a greater need to keep it to support spending
in retirement. Many households have expressed
heightened concern about their financial security in
old age, which reportedly has led to increased
provision for retirement. The results of a survey
conducted annually by the Roper Organization, which
asks individuals about their confidence in the Social
Security system, shows that between 1992 and 1996 the
percent of respondents expressing little or no
confidence in the system jumped from about 45 percent
to more than 60 percent.

Moreover, consumer debt burdens are near
historical highs, while credit card delinquencies and
personal bankruptcies have risen sharply over the past
year. These circumstances may make both borrowers and
lenders a bit more cautious, damping spending. In fact,
we may be seeing both wealth and debt effects already at
work for different segments of the population, to an
approximately offsetting extent. Saving out of current
income by households in the upper income quintile, who
own nearly three-fourths of all non-pension equities
held by households, evidently has declined in recent
years. At the same time, the use of credit for
purchases appears to have leveled off after a sharp
runup from 1993 to 1996, perhaps because some
households are becoming debt constrained and, as a
result, are curtailing their spending.

The Federal Reserve will be weighing these
influences as it endeavors to help extend the current
period of sustained growth. Participants in financial
markets seem to believe that in the current benign
environment the FOMC will succeed indefinitely. There
is no evidence, however, that the business cycle has
been repealed. Another recession will doubtless occur
some day owing to circumstances that could not be, or
at least were not, perceived by policymakers and
financial market participants alike. History
demonstrates that participants in financial markets are
susceptible to waves of optimism, which can in turn
foster a general process of asset-price inflation that
can feed through into markets for goods and services.
Excessive optimism sows the seeds of its own reversal
in the form of imbalances that tend to grow over time.
When unwarranted expectations ultimately are not
realized, the unwinding of these financial excesses can
act to amplify a downturn in economic activity, much as
they can amplify the upswing. As you know, last
December I put the question this way: "...how do we
know when irrational exuberance has unduly escalated
asset values, which then become subject to unexpected
and prolonged contractions ...?"

We have not been able, as yet, to provide a
satisfying answer to this question, but there are
reasons in the current environment to keep this
question on the table. Clearly, when people are
exposed to long periods of relative economic
tranquility, they seem inevitably prone to complacency
about the future. This is understandable. We have had
fifteen years of economic expansion interrupted by only
one recession--and that was six years ago. As the
memory of such past events fades, it naturally seems
ever less sensible to keep up one's guard against an
adverse event in the future. Thus, it should come as
no surprise that, after such a long period of balanced
expansion, risk premiums for advancing funds to businesses
in virtually all financial markets have declined to near-
record lows.

Is it possible that there is something
fundamentally new about this current period that would
warrant such complacency? Yes, it is possible.
Markets may have become more efficient, competition is
more global, and information technology has doubtless
enhanced the stability of business operations. But,
regrettably, history is strewn with visions of such
"new eras" that, in the end, have proven to be a
mirage. In short, history counsels caution.

Such caution seems especially warranted with
regard to the sharp rise in equity prices during the
past two years. These gains have obviously raised
questions of sustainability. Analytically, current
stock-price valuations at prevailing long-term interest
rates could be justified by very strong earnings growth
expectations. In fact, the long-term earnings
projections of financial analysts have been marked up
noticeably over the last year and seem to imply very
high earnings growth and continued rising profit
margins, at a time when such margins are already up
appreciably from their depressed levels of five years
ago. It could be argued that, although margins are the
highest in a generation, they are still below those
that prevailed in the 1960s. Nonetheless, further
increases in these margins would evidently require
continued restraint on costs: labor compensation
continuing to grow at its current pace and productivity
growth picking up. Neither, of course, can be ruled
out. But we should keep in mind that, at these
relatively low long-term interest rates, small changes
in long-term earnings expectations could have outsized
impacts on equity prices.

Caution also seems warranted by the narrow yield
spreads that suggest perceptions of low risk, possibly
unrealistically low risk. Considerable optimism about
the ability of businesses to sustain this current
healthy financial condition seems, as I indicated
earlier, to be influencing the setting of risk
premiums, not just in the stock market but throughout
the financial system. This optimistic attitude has
become especially evident in quality spreads on high-
yield corporate bonds--what we used to call "junk
bonds." In addition, banks have continued to ease
terms and standards on business loans, and margins on
many of these loans are now quite thin. Many banks are
pulling back a little from consumer credit card lending
as losses exceed expectations. Nonetheless, some bank
and nonbank lenders have been expanding aggressively
into the home equity loan market and so-called
"subprime" auto lending, although recent problems in
the latter may already be introducing a sense of
caution.

Why should the central bank be concerned about the
possibility that financial markets may be
overestimating returns or mispricing risk? It is not
that we have a firm view that equity prices are
necessarily excessive right now or risk spreads
patently too low. Our goal is to contribute as best we
can to the highest possible growth of income and wealth
over time, and we would be pleased if the favorable
economic environment projected in markets actually
comes to pass. Rather, the FOMC has to be sensitive to
indications of even slowly building imbalances,
whatever their source, that, by fostering the emergence
of inflation pressures, would ultimately threaten
healthy economic expansion.

Unfortunately, because the monetary aggregates
were subject to an episode of aberrant behavioral
patterns in the early 1990s, they are likely to be of
only limited help in making this judgment. For three
decades starting in the early 1960s, the public's
demand for the broader monetary aggregates, especially
M2, was reasonably predictable. In the intermediate
term, M2 velocity--nominal income divided by the stock
of M2--tended to vary directly with the difference
between money market yields and the return on M2
assets--that is, with its short-term opportunity cost.
In the long run, as adjustments in deposit rates caused
the opportunity cost to revert to an equilibrium, M2
velocity also tended to return to an associated stable
equilibrium level. For several years in the early
1990s, however, the velocities of M2 and M3 exhibited
persisting upward shifts that departed markedly from
these historical patterns.

In the last two to three years, velocity patterns
seem to have returned to those historical
relationships, after allowing for a presumed permanent
upward shift in the levels of velocity. Even so, given
the abnormal velocity behavior during the early 1990s,
FOMC members continue to see considerable uncertainty
in the relationship of broad money to opportunity costs
and nominal income. Concern about the possibility of
aberrant behavior has made the FOMC hesitant to upgrade
the role of these measures in monetary policy.

Against this background, at its February meeting,
the FOMC reaffirmed the provisional ranges set last
July for money and debt growth this year: 1 to 5
percent for M2, 2 to 6 percent for M3, and 3 to 7
percent for the debt of domestic nonfinancial sectors.
The M2 and M3 ranges again are designed to be consistent
with the FOMC's long-run goal of price stability:
For, if the velocities of the broader monetary
aggregates were to continue behaving as they did before
1990, then money growth around the middle portions of
the ranges would be consistent with noninflationary,
sustainable economic expansion. But, even with such
velocity behavior this year, when inflation is expected
to still be higher than is consistent with our long-run
objective of reasonable price stability, the broader
aggregates could well grow around the upper bounds of
these ranges. The debt aggregate probably will expand
around the middle of its range this year.

I will conclude on the same upbeat note about the
U.S. economy with which I began. Although a central
banker's occupational responsibility is to stay on the
lookout for trouble, even I must admit that our
economic prospects in general are quite favorable. The
flexibility of our market system and the vibrancy of
our private sector remain examples for the whole world
to emulate. The Federal Reserve will endeavor to do
its part by continuing to foster a monetary framework
under which our citizens can prosper to the fullest
possible extent.